Forecast Errors in Budget 16 Highlight Fiscal Risks for 2017

This blog has argued that Ireland should not have moved its Budget date from December to early October, as it increases the risks of  forecasting errors, which history shows can be large. That was again evident in 2016, but what is also revealing, and perhaps ominous, is that the final fiscal outturn was also very different to that expected less than three months earlier, making the 2017 targets more challenging than initially thought.

The 2016 Budget envisaged the State running a current budget surplus of €0.5bn, offset  by a capital deficit of €2.1bn , so leaving a borrowing requirement of €1.6bn. Current spending was projected to rise modestly, by 1.6%, and tax receipts were forecast to increase by 3.6%: Corporation tax had spectacularly exceeded the target in the previous year , by 50%, and was now expected to decline modestly. but offset by stronger tax headings elsewhere, notably from VAT, which was projected to grow by 7.7%.

As the year unfolded  it became clear that tax receipts were running well above profile and by end-June were €740m or 3.4% above expectations, with corporation tax again well ahead of target, accompanied by excise duties. VAT was running behind profile but over the summer the Department of Finance projected a new tax outturn for the year, with receipts now expected to be €900m above the original figure,  partly offset by higher current spending. These new projections were again reiterated in October, with the current budget surplus now expected to emerge modestly higher at €0.7bn , with the overall deficit slightly lower than originally projected, at €1.4bn.

That earlier tax buoyancy fell away in the latter part of 2016, however, and tax receipts came in over €600m ahead of the original target but well shy of the €900m overshoot pencilled in. Indeed,  by end- December, most tax headings fell short of the forecasts made only a few months earler, including VAT (-210m) and Corporation tax (-€150m). Furthermore, current spending actually finished the year below the original target and a full €550m below the higher figure announced over the summer, so the government could not spend all it hoped.

Non-tax revenue also emerged well away for the revised target, this time to the upside, and the net effect was a current budget surplus of €1.3bn, some €0.8bn above the original Budget target and €0.6bn ahead of the forecast made a few months ago. The capital deficit was slighly higher than forecast, leaving an overall deficit of €1bn.

So the forecast errors in 2016, as in 2015, came in on the ‘right side’ , resulting in a smaller than expected deficit, but  implying that the Government could have spent more than it had initially thought, while  still hitting the fiscal targets. The forecast errors can also be on the ‘wrong side’ of course,  and the 2016 outturn   now means that tax receipts have to grow by 5.8% to reach the 2017 target, instead of 5.2%, with the required rise in VAT now 7.7% ( was 5.9%) and 5.0% for Corporation tax ( was 2.9%). The 2017 fiscal arithmetic therefore looks more challenging than it did when the Minister presented the Budget just a few months ago.

Ireland should move the Budget back to December

The last three Irish Budgets have been presented in mid-October, a departure from  the previous practice of delivering them later in the year, usually in early December. The change was triggered by new Euro  rules designed to improve economic surveillance (the two-pack)  which stipulated that member States ‘ must publish their draft budgets for the following year’ by October 15, although budgets need not be adopted till December 31. Ireland chose to present and adopt the Budget at the earlier date although others do not pass theirs till later in the year, and there are a number of reasons why the Irish Government should consider publishing a broad outline of its fiscal targets in October but wait till December to adopt the full Budget.

Ireland’s GDP is much more volatile than the norm across developed economies, which makes for large forecasting errors in terms of  economic activity and tax receipts ; the average  annual forecast error for the Exchequer balance  since 2000 is €1.5bn. Forecasting  the following year is difficult enough in early December as  the only published GDP data relates to the first two quarters of the year but at least there is some available information about the third quarter, which is not the case in mid-October.

Another factor is the November tax month, which includes income tax from the self-employed and is also a big month for corporation tax; in 2015, for example, total  receipts in November were expected to be  €6.5bn against a monthly average over the rest of the year of €3.3bn. Consequently, a much stronger or weaker November inflow may  not only render redundant the end-year fiscal projections made in October  but also compromise the forecast made for the  year ahead.

The past few months has highlighted that risk in Ireland, albeit this time  with the forecast errors on the positive side. The 2015 Budget projected tax receipts of €42.3bn, or 2.5% above the 2014 outturn, and it became clear as the year unfolded that economic growth was running well above expectations and  tax receipts would substantially exceed the initial target, albeit largely due to a massive overshoot in one category, corporation tax. In  October the Government formally revised up its tax forecast for the year, by €2.3bn to €44.6bn and announced additional spending of €1.5bn. The projected Exchequer deficit  was also reduced from the initial €6.5bn to €2.8bn, reflecting unbudgeted  capital receipts as well as the tax bounty. The Exchequer balance is a cash based measure  and the broader General Government deficit  (the preferred  EU fiscal metric) for 2015 was also revised down, to 2.1% of GDP from 2.7%, with a 2016 target of  1.2%.

The November Exchequer returns  have changed the picture. Receipts in the month came in at €6.9bn or €470mn above profile, leaving the overshoot year to date at €2.9bn, with corporation tax 58% or €2.3bn above expectations, a spectacular forecasting error. Spending is also still running behind the original target, so it appears unlikely  the Exchequer will actually meet the higher spending figures announced in October. The net result is that tax receipts will probably end the year at €45.4bn, 10% above the 2014 outturn and €800mn above the official estimate made just six weeks ago. That and the fact that the revised spending target will not be met implies an Exchequer deficit  of €1bn or less and a General Government deficit of 1.7% of GDP. Moreover,the Exchequer estimate does not include the €1.6bn payable from the partial redemption of AIB’s Preference shares so  a cash surplus for the year is possible, depending on when the money is transferred,

The 2016 Budget projected  a 5.8% rise in tax receipts which now implies a tax figure of €48bn next year or €0.8bn above the existing forecast, which even with the same spending targets gives a General Government deficit of 0.9% of GDP instead of the budgeted 1.2%. Of course there is no guarantee that  the 2016 tax receipts will emerge on target ( particularly in relation to corporation tax) but on the face of it fiscal policy in Ireland was tighter than the authorities wanted it to be in 2015 and will now be tighter than planned in 2016. Government debt will be lower as a result on this occasion but a return to a December Budget would probably reduce the  scale of forecast errors, although not eliminating them.

What if the electorate is reckless?

It is now received wisdom that the Irish authorities pursued bad or at least inappropriate economic policy in the years before the 2008  crash .Fiscal policy is usually seen as one culprit, with Budgets perceived as fuelling the boom rather than dampening down economic activity. Fiscal policy should have been counter-cyclical, it is argued, with the government of the day seen as culpable in not’ doing the right thing’. If we ignore the hindsight bias present in such analysis it also begs a simpler question- what if the electorate does not reward prudent policies and prefers what by normal economic criteria would be considered reckless ones?

In Ireland’s case the counter-cyclical argument is that the government should raise taxes and/or cut discretionary spending when the economy is growing too fast ( leaving aside the problem of establishing what is sustainable growth at the time). Yet commentary on the Budget and the monthly Exchequer returns is predicated on exactly the opposite- strong growth in tax receipts is seen as opening the door for higher public spending and ‘ a giveaway’ when next the Finance Minister delivers his Budget address to the nation.

A glance at the 2007 general election manifestos, for example, shows that all the main political parties envisaged tax cuts and further strong growth in exchequer spending . Were the politicians being irresponsible or simply rational, based on the belief that electorates want higher spending and lower taxes and will not reward a government which indeed adopts a counter cyclical policy, even if the need for that was  perceived clearly at the time ?

There are additional constraints other than the electorate, although perhaps not well understood by voters. One is the fiscal rules imposed by membership of the euro, and these have tightened considerably since 2010, including the stipulation that Ireland will need to limit current government spending in the medium term and to run a persistent Budget surplus when adjusted for the economic cycle. It remains to be seen what role these constraints will play in shaping the next general election.

The new fiscal pact also resulted in the setting up of the Irish Fiscal Advisory Council, which is there to assess the budgetary stance and monitor compliance with the fiscal rules. Yet it does not appear to resonate with the public and the government has ignored its recent advice, to no great media  clamor or cost in terms of public opinion.

The markets, too, play a role, and can punish profligate governments. Yet bond yields across the euro zone are generally at record lows, despite the fact that debt burdens are still rising, so QE has apparently trumped that potential constraint, at least for a while.

The issue of the electorate’s role in shaping policies is currently on show  in Greece, where the new Government is seen to have a mandate to end austerity, kick out the troika  and yet secure additional funding from Greece’s creditors. It is unclear how they can pull this off but the electorate has spoken. Yet the same electorate has tolerated the fact that no Greek government has run a Budget surplus in 34 years ( and no doubt longer but that is the limit of the IMF data base) with the average deficit amounting to 7.7% of GDP over that period. Clearly the Greek electorate are willing for future generations to pick up the tab. Some might say this is irresponsible while others seek to blame the creditors for funding what must qualify as reckless behaviour.

 

Ireland’s fiscal adjustment-too soon to know

Ireland’s 2015 Budget is four months away but the debate about the scale of fiscal adjustment required has intensified, with contributions from the IMF, the Irish Fiscal Advisory Council, the Minister for Finance and  other assorted politicians. Some argue for the €2bn figure  set out some time ago while others claim that  a lower figure will suffice. In truth it is far too early to be definitive as there is a high degree of uncertainty , both about the fiscal outlook and prospects for the Irish economy, and given this lack of clarity it is puzzling that so many can take a dogmatic position.

Ireland’s total fiscal adjustment since 2008 amounts to some €30bn, and was required to keep the fiscal deficit on a declining path with a target for the latter of under 3% of GDP by the end of 2015. So the adjustment in any given Budget, be it cuts to government spending or measures to raise additional revenue, is a residual with the size determined by the forecast deficit ratio in the absence of any new policy measures. Note that the target is not the actual deficit itself but the deficit relative to GDP, so there are two areas of uncertainty, one relating to the performance of the economy and the other to the evolution of exchequer spending and receipts, although the latter is of course strongly influenced by the pace of economic activity. Inevitably, the actual deficit and the level of GDP will diverge from that forecast, making any projected adjustment less meaningful, particularly into the medium term. Yet in recent years the forecast Irish fiscal adjustment figure has become  a target in itself, rather than the residual. Some claim that sticking to an announced adjustment enhances credibility, which seems to be the IMF view, although it is not clear why a figure projected a few years earlier must be adhered to even if circumstances have changed, and given that such adjustments will dampen economic activity.There is also a temptation for the government to ‘spin’ the Budget presentation in order to be seen to ‘achieve’ the  previously announced adjustment.

Take the 2013 Budget. The  adjustment figure ahead of time was seen as €3.5bn and according to the  pre-Budget Estimates  the 2013 fiscal deficit would be €15bn, or 8.9% of forecast GDP , on unchanged policy.The deficit target was set at 7.5% of GDP, with an actual deficit of  €12.7bn, and the government duly proclaimed an adjustment of €3.5bn, even though the measures announced on Budget day amounted to €2.8bn, with the remainder mainly due to ‘carryover’ effects from previous spending and revenue decisions. In the event the deficit came in almost €1bn below forecast, at €11.8bn, thanks to a significant overestimation of debt interest  and higher non-tax receipts than projected, including profit from the Central Bank. However, real GDP actually contracted in 2013 instead of growing as expected and nominal GDP emerged €3.6bn lower than forecast, so the deficit ratio came in only marginally below target, at 7.2% of GDP, despite the much better than projected outturn in the deficit itself.

The 2014 Budget projected a deficit of €9.8bn in the absence of any adjustments, or 5.8% of forecast GDP. Consequently, policy measures were required to hit the deficit target , announced at 4.8% of GDP, with an adjustment figure of around €3.0bn widely discussed. Indeed, that was the figure announced by the Minister ( actually €3.1bn ) although the measures introduced on the day amounted to just €1.9bn, with the residual due to the familiar ‘carryovers’ and  previously unidentified ‘resources’ on the expenditure side , including ‘savings’ and lower debt interest. So the €3bn ‘adjustment’ was anything but, although the announced measures are forecast to reduce the deficit to €8.2bn, or 4.8% of GDP.

Five months into the year  the authorities are confident that the deficit figure will be achieved and  tax receipts are running 2.9% ahead of profile, which may persuade the Department of Finance to revise up their tax projections for 2015, hence implying a lower deficit figure before any adjustments. It is early days yet, however, as we do not  even know how Ireland’s GDP performed in the first quarter- retail sales have picked up at the headline level but the value of merchandise exports actually fell on an annual basis in q1 thanks to a decline in price, which will dampen nominal GDP. Uncertainty over the latter is also compounded by the change to a new standard for national accounts (ESA 2010) which will count R&D as capital spending for the first time,  and this along with other minor changes may boost the level of Irish GDP  by 2% or more and so impact the deficit ratio, albeit marginally.

So it is by no means clear at this stage what adjustment will be required to meet a 3% deficit target next year, be it  lower or indeed a higher figure. Austerity fatigue has set in across many European countries and the IMF call to maintain a previously forecast adjustment can be seen in that light, but any adjustment involves serious economic and social costs and  is a means to an end rather than an end in itself.